Rolls trading through fail is seen as an indication of the growing supply/demand imbalance in the mortgage market, said analysts from JPMorgan Securities in a recent report. They said that currently most rolls are trading near 0% implied financing.
In fact, there are even a few peculiar exceptions stubbornly trading at negative financing. For instance, analysts said that the Dwarf 5 roll traded about a quarter tick through fail over the last two months and is currently trading at 12.5/32s for January/February, which is almost a plus through fail. This is in direct contrast to the zero-percent implied financing for the FNMA 5.5 roll, they said, which looks paltry. This roll is already at fail for February/March.
Researchers asked the question: If it is really cheaper to fail on a security rather than deliver it in the front month, then why doesn't everyone fail?
They explained that it is generally believed in the roll market that the implied financing should never be higher than the repo rate and never be lower than zero. If the implied financing were on top of the repo rate, buysiders could then buy the roll (take delivery in the front month), and finance the purchase at the repo rate, and this would allow them to make "free" money. This actually gives them the chance to collect the difference between the roll and the repo rate at no risk.
The researchers also explained that having a roll trading special is not necessarily an arbitrage opportunity, because the monthly TBA delivery option can hold significant value. But when the implied financing is negative then there is an "arbitrage." Thus JPMorgan suggests for buysiders to sell the roll when it is more expensive than the cost of failing. They added that these arbitrage arguments almost always maintain the implied financing from the rolls between the repo rate and zero (usually closer to repo).
However, they also stated that defying the laws of nature, the Dwarf 5 roll is bid almost a plus through fail. The one thing wrong with this is that perpetual fails are actually possible with current TBA delivery rules. For instance, analysts said that good delivery for a January 2003 short would require pools created in January 2003 or earlier. Post- January 2003 production would not be good delivery.
Therefore, in some instances, investors may still buy the roll through fail to avoid the risk of "perpetual fail." They said that the fact that investors are concerned about this issue when the outstanding float in Dwarf 5s (or new issue net of CMOs) is roughly at $35 billion is telling. They added that another factor that is pushing the roll through fail is the cost to a dealer of failing on CMOs (especially for Freddie Mac Golds).
Meanwhile, analysts from Banc One Capital Markets recently released a report on rolling. They said that it currently makes a lot of sense to look into more aggressive investments than repo. The analysts added that the bid/ask spread on a high-quality floater is merely a plus, so investing proceeds can serve as a value-enhancing idea even if the roll does not remain special past the current month. Apparently, the longer the roll is expected to remain special, or the more yield is increased by adding more structure or credit risk, the higher the return that will be earned by the investor. Analysts suggested that employing a floating rate ABS or CMO along with a roll can add meaningful value to portfolios, especially for those who expect rolls to remain special.
